Funds react to inflation, slowdown

Asset allocations adopted in the midst of a 40-year run of low inflation and sinking bond yields may be in need of a rework in the new higher inflation normal.

After the Federal Reserve launched one of the most aggressive interest rate boosting cycles in decades amid soaring inflation, investors are having to come to terms with the new economic environment, which some say could be heading toward stagflation.

That shift is also impacting their asset allocations, industry insiders said.

"I think our asset allocation is wrong," said Sung Won Sohn, a board member of the $21.5 billion Los Angeles City Employees' Retirement System, at its June 13 meeting. LACERS officials plan to embark on an asset allocation study early next year.

LACERS' asset allocation, adopted by the board three years ago, falls short because it was based on expected continued low inflation and a low interest rate, said Mr. Sohn, who is also a professor of finance and economics at Loyola Marymount University, Los Angeles.

"The world does change," he said. "I felt inflation would be very high" when the board was in the midst of the last asset review three years ago. "I wish I was wrong."

Pension funds and other asset owners are having very different conversations. This year, investors and their consultants are concluding they need to make sure their return expectations and their asset class choices are in line with new economic realities.

So far this year, the $309.3 billion California State Teachers' Retirement System, West Sacramento; $180.4 billion Florida Retirement System, Tallahassee; $87.9 billion Ohio Public Employees' Retirement System, Columbus; $43.1 billion New Mexico State Investment Council, Santa Fe; and $10.7 billion Chicago Public School Teachers' Pension & Retirement Fund have adopted new asset allocations or are on the road to doing so.

"In some ways higher inflation and higher (federal) funds rates did change our long-term asset return assumptions for each of our asset classes, especially for those that are inflation-rate sensitive," said Alison Adams, Portland-based managing principal and a research consultant on the capital markets research team at Meketa Investment Group.

In 2019, when Treasury bonds yielded 2.5%, institutional investors had to decide how risky a portfolio they had to have to get to a 6.5% to 7.5% assumed rate of return, Ms. Adams said.

"Now with government bonds providing healthy yields, it has changed that assumption," she said.

Unlike just a few years ago, investors are considering whether to incorporate more inflation-sensitive assets into their portfolios, Ms. Adams said.

"In 2019, you couldn't get some people to buy TIPS (Treasury inflation-protected securities) to save your life. Now many want TIPS and inflation-sensitive fixed income," Ms. Adams said.

In May, CalSTRS adopted a new asset allocation, cutting its public equity target by 4 percentage points to 38%, boosting fixed income by 2 percentage points to 14% — with most of it aimed at private credit — and increasing its private equity and inflation-sensitive allocations by 1 percentage point each to 14% and 7%, respectively.

As part of its analysis, CalSTRS asked its general investment consultant, Meketa Investment Group, to include stagflation, deglobalization and, for the first time, climate change in its portfolio modeling. Stagflation — a decade or more of high inflation and slow global GDP growth — would be worse for CalSTRS' portfolio then any other factor, Meketa's report showed.

When there is stagflation, no asset class does well, said CIO Christopher Ailman at the May meeting.

"It's an environment in which it is hard to make money in anything," Mr. Ailman said. "Diversity doesn't work because everything is stuck in the mud."

Stephen P. McCourt, Meketa managing principal and co-CEO, said at the same meeting that those who believe that the global economy is now in a period of stagflation say it is due to the reversal of globalization.

Over the past four decades, global trade increased every year, mostly from China joining the global economy, which acted as a tailwind to earnings and global capital markets, Mr. McCourt explained. Another positive side effect of globalization was lower inflation, he said.

"We outsourced all of our jobs to people who would do it cheaper," Mr. McCourt said. When inflation is low, bond yields also drop and asset prices go up, he said.

"Most of what we experienced in our lifetimes has been a gentle tailwind that has helped global markets," he said.

CalSTRS officials acknowledge that asset allocation is an art and a science. The science is the numbers but the art is "we don't know what we don't know," said Geraldine Jimenez, senior investment director of public markets, at the pension fund's May meeting.

That's why, historically, CalSTRS has been increasing the diversification of its portfolio by adding new asset classes and reducing global equities, Ms. Jimenez said.

Four years ago, CalSTRS added a 10% risk-mitigating strategies allocation.

The new asset allocation CalSTRS adopted in May includes exposure to direct lending for the first time, Ms. Jimenez said. CalSTRS officials expect direct lending to complement its existing publicly traded credit portfolio by improving the fund's risk-adjusted returns. It also will add "modest" diversification by shifting assets from global equity to direct lending, which has "a relatively more stable income profile," a report to the investment committee said.

The best answer to the unknowns is "staying diversified and increasing our diversification," Ms. Jimenez said.

In today's new normal, some of the asset classes investors previously turned to in higher inflation environments are facing challenges, Meketa's Ms. Adams said.

Real estate is one of those.

"Real estate is generally something you want to hold when inflation is higher for longer, except some of these real estate vehicles are under some pressure," Ms. Adams said.

And then there is the health of private real estate if interest rates go up even higher, she said.

"What would that do for real estate valuations? Will landlords be able to increase rents?" Ms. Adams queried.

An asset class that investors often turn to when they wanted to reach for yields was emerging markets, Ms. Adams said.

But with U.S.-China trade tensions quite high, emerging markets may no longer be where investors would go to find that additional return needed to reach the 6.5% to 7.5% return that an institutional investor might expect, she said.

Inflation should settle out much higher than it was in the last cycle, said Indrani De, New York-based head of global investment research at FTSE Russell, a London Stock Exchange Group business.

"Investment-grade bonds will do better than equities for the first time in a very long time," Ms. De said.

High yield is very correlated to equities and so in this cycle, investors will get more diversification benefits from investment-grade bonds, she said.

While no one can be sure, in the coming cycle, equities could have a lower return than in the past, Ms. De said.

However, developed and emerging market equities are becoming more uncorrelated and should continue this trend over the next 10 or 11 years, which provides asset owners more opportunity for diversification, she said.

Among alternative investments, there has been more dispersion of returns, which requires investors to be more selective.

According to a June FTSE Russell report, listed infrastructure has outperformed listed real estate over the past year. Within listed real estate, there was significant dispersion in returns with data centers doing the best and office sector performing the worst, the report said.

Private market versions of listed asset classes are expected to follow suit. Industry research in general shows that private real estate, infrastructure and private equity returns generally follow listed real estate, infrastructure and equities by two to three years, Ms. De said.